1

Foreign Exchange Management

1

• Foreign exchange or Forex is the conversion of one country's currency into that of another.

• A country's currency is valued according to factors of supply and demand

• A currency's value can be pegged to another country's currency, such as theU.S. dollar, or even to a basket ofcurrencies

2

What Is Forex?

What is Currency?

3

• Currency refers to the physical aspects of a nation’s money supply.

• “Currency notes" means and includes cash in the form of coins and bank notes. (Section 2(i) FEMA).

• "Indian currency" means currency which is expressed or drawn in Indian rupees but does not include special bank notes and special one rupee notes issued under section 28A of Reserve Bank of India Act, 1934 (these are issued on special occasions like Gandhi centenary etc.). (Section 2(q) FEMA)

Number of Currencies in the World

Out of the 193+ countries, there are about 167 national official currencies in the world.

4

What is Forex Market?

5

The foreign exchange market refers to the network of individuals, banks and organized financial exchanges that trade global currencies.

5

• Is an over the counter market.• Through it we can convert one country’s

currency into another.• Forex markets are quite decentralized.• Participants like market makers,

brokers, corporate and individual customers are physically separated from each other.

12/3/2012

What is Forex Market?

6

History of Forex Market

7

• The creation of the gold standard monetary system in 1875 marks one of the most important events in the history of the forex market.

• Before the gold standard was implemented, countries would commonly use gold and silver as means of international payment.

• The main issue with using gold and silver for payment is that their value is affected by external supply and demand.

International Monetary System

8

• International monetary systems are sets of internationally agreed rules, conventions and supporting institutions that facilitate– international trade,– cross border investment and– generally the reallocation of capital between nation

states.

• They provide means of payment acceptable between buyers and sellers of different nationality, including deferred payment.

Forex Market Players

9

• Commercial Banks• Central Banks• Corporates• Individuals

1012/3/2012

EUR/USD: The euro and the U.S. dollarUSD/JPY :The U.S. dollar and the Japanese yenGBP/USD: The British pound sterling and the U.S. dollarUSD/CHF: The U.S. dollar and the Swiss franc

Major Forex Currencies

Top 10 currency traders

11

1 Deutsche Bank

2 Barclays Capital

3 UBS AG

4 Citi

5 JPMorgan

6 HSBC

7 Royal Bank of Scotland

8 Credit Suisse

9 Goldman Sachs

10 Morgan Stanley

• Spot markets• Forward markets• Futures markets • Options markets• Swaps markets

1212/3/2012

Foreign Exchange Markets

www.caaa.in 23

• The economic liberalization provided the economic rationale for the introduction of FX derivatives.

• According to data compiled by Switzerland- based Bank for International Settlement (BIS) India has the fastest increase in market share in comparison with other countries in the world.

12/3/2012

Forex Market in India

13

Role of RBI

14

• Management of money Supply /inflation

• Management of exchange rates• Ensuring orderly markets

Factors Effecting Rates, Short Term

15

• Time scale in forex• Supply/demand position• Movement of funds• Entry of a large Banks / Corporates• Political crises, wars, oil price• Central Bank intervention

Factors Effecting Rates, Long Term

16

• Economic fundamentals/data• Balance of payments• Govt.’s economic policies• Interest rate changes• Capital movements• Technical/psychological factors• Purchase power parity• Interest rate parity

Determination of Exchange Rates

17

• Balance of payments• Demand and supply• Purchasing power parity• Interest rate• Relative income levels• Market expectations

Forward Exchange Rates

18

• The forward rate is a price quotation to deliver the currency in future.

• The exchange rate is determined at the time of concluding the contract,

• But payment and delivery are not required till maturity.

• Foreign exchange dealers and Banks give the forward rate quotations for delivery in future according to the requirement of their clients.

Foreign exchange Reserves

19

• Foreign exchange held by a nation is one way to measure a country's economic power.

• As on December 2015 –– China stood No 1 with FE reserves:

$3,345,920 millions– Japan stood at No 2 with FE reserves: $

1,207,080 millions– Saudi Arabia stood at No 3 with FE

reserves:$615,985 millions

– India stood at No 8 with FE reserves:$ 333,141 millions

– The United States stood at 14 with FE reserves: $ 107,170 millions

20

Foreign Exchange Risks

21

• Transaction Risk• Translation Risk• Economic Risk

Transaction Risk

22

• The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates.

• Whoever makes a contract denominated in a foreign currency bears transaction risk.

• Ocean Drilling has transaction risk if it borrows money in French francs or Japanese yen, and Hintz-Kessels-Kohl has transaction risk if it agrees to accept future payments for its vehicles in U.S. dollars.

Translation Risk

23

• Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them.

• Every company having at least one subsidiary using a different functional currency bears translation risk.

• MSDI has translation risk from having a subsidiary, MSDI Alcala de Henares, whose financial statements are kept in Spanish pesetas and not in U.S. dollars.

Economic Risk

24

• Changes in competitive position as a result of permanent changes in exchange rates.

• Every company buying or selling abroad or even just competing with foreign companies has economic risk.

• Maybach has economic risk from manufacturing its automobiles in Germany for export to the United States, where it competes with Rolls Royces manufactured in England.

Other Classifications of Forex Risks

25

• Exchange risk• Credit risk• Liquidity risk• Settlement risk• Operational risk• Compliance Risk

Forex Management

26

• Effective forex management minimizes the economic risks, while providing cash flow to meet everyday expenses and improve earnings.

• Foreign exchange management requires its participants to enter the market to deliver and accept currencies at fluctuating exchange rates.

Managing Forex is all about……..

27

• Foreign Exchange Management requires you to follow current events that translate into fluctuating exchange rates for a particular country.– Savers prefer to do business in nations

that feature stable governments and strong economies.

Managing Forex is all about……..

28

• Investors may liquidate overseas holdings in the case of economic recession and political instability that is attributable to a particular country.– For example, businesses would quickly sell

assets and retreat from a nation that is undergoing military coup where the new regime is hostile to foreign investors.

Managing Forex is all about……..

29

• Identifying the distinct risks of transacting global business.

• Foreign exchange management analyzes the economic records of prospective countries---in order to uncover and buy undervalued currencies.– The goal is to hold these notes until exchange rates

improve to mirror favorable developments, such as strong national employment reports and falling budget deficits. Successful currency trading increases profitability and buying power.

Managing Forex is all about……..

30

• Foreign exchange management may use diversification and currency derivatives to manage risks and preserve profits.– Currency derivatives are bought to establish

predetermined exchange rates for set periods.– These derivatives include futures, options and

forwards.– Currency futures and options trade on organized

exchanges, such as the Chicago Mercantile Exchange.– Forwards, however, are customized agreements between

two parties to negotiate future exchange rates between themselves.

Managing Forex is all about……..

31

• Smaller investors may elect to diversify with mutual funds according to geography, instead. For example, high commodity costs may lead Japan into economic recession, while mutual funds investing in resource-rich Russia are making money.

Identifying,

Measuring,Monitoring & Managing

Risks

32

Derivatives

33

• Use of Derivatives in Risk Management– Derivatives are contracts whose values are to

be derived from the assets covered by them– Exchange Rate Risk : Forwards, Options,

Futures, Range forwards (Floors, Collars, Caps)

– Interest Rate Risk : FRAs, Options, Futures, IRS

– Liquidity/Currency Risks : Currency Swaps/ Swaptions,

Foreign Exchange Derivative Contracts

34

• Derivative contracts are governed by the Foreign Exchange Derivative Contracts Regulations, 2000 (Notification No. FEMA 25/2000-RB).No person in India can enter into a foreign exchange derivative contract or currency futures without the prior permission of the Reserve Bank.

Permission to enter into a Foreign Exchange Derivative contract

35

• A person resident in India can enter into a foreign exchange derivative contract to hedge an exposure to risk in respect of a transaction permissible under the Act.

• This should be in accordance with the provisions contained in Schedule I.

Options

36

• A stipulated privilege to receive/deliver a security commodity / currency, at a given price, with in /on aspecified date.

• Confers a right with no obligation whereby the buyer can demand a purchase or sale by the writer of a specified amount of currency / number of bonds / shares, commodities

• There are two types of options(1) Call option which gives a right to purchase

(2) Put option, right to sell

Interest Rate Swaps

37

• Helps create the right mix of short term and long term assets and liabilities, while controlling the interest rates attached to them

• No exchange of principal but only interest difference on a notional amount

• Interest rate risk can be shifted, by converting a floating rate to fixed rate or vice-versa

• Interest payments made in the same currency

Currency Swaps

38

• Currency swaps help hedge currency risk and companies can freely change the currencies in which they pay and receive

• Liabilities and assets can be restructured

• Balance sheet transaction risks can be hedged

• Surplus in one currency can be used to take care of funding in another currency

•• Interest payments are made in two currencies

• Currencies and principal are exchanged at a pre-fixed rate at the beginning and end, of the contract period.

Futures

39

• An agreement to buy or sell a standard quantity of an asset at a future date at a price agreed through an open cry on the Futures exchange.

• Quantity, quality, date of delivery, units of price, minimum change in price, location for settlement are standardized

• American and European style

Forex Risk Mitigation

40

• Multi currency budgeting• Cash and funds flow projections• Multi currency pricing and invoicing• Asset- liability management in a multi currency

environment• Dynamics of a multi currency balance sheet

• Appetite for risk

Managing risks in

foreign exchange markets is

NOT easy! But………

41

Interesting &

Rewarding!!!!

42

43